If you hadn’t heard of rating agencies before, you heard about them a few weeks ago during the great debt ceiling debates.
The "Big Three" rating agencies (oligopoly anyone?): Standard & Poor’s, Moody's and Fitch, are a source of information for investors who are trying to determine the creditworthiness of borrowers. That means rating agencies offer their opinions about the quality of bonds issued by corporations, mortgage securitization firms and governments. AAA is the best rating, AA is next, then A… all the way down to DDD, the junkiest of junk bonds (and there are pluses and minuses attached to these ratings as well).
Bond credit rating agencies used to be paid for their work by investors who wanted impartial information on the credit worthiness of securities issuers and their offerings. Makes sense, right?
Then, in the early 1970s, the "Big Three" rating agencies began to receive payment for their opinions by the securities issuers themselves. Bad news. Obviously, this creates a huge conflict of interest.
For example, say I want to issue a bond called Justin’s Bond. Potential investors in Justin’s Bond want to be assured that, if they invest in my bond, they’ll get their money (plus interest) back. So my potential investors will look to a credit rating agency for guidance. After all, they don’t want to spend the time or money themselves to research Justin.
The odd thing is that I, the issuer of Justin’s Bond, actually pay a rating agency to rate my creditworthiness. Maybe I get the sense that S&P will only give me a AA rating so I shop around a bit and find that Fitch will give me the coveted AAA rating, which will make my bond much more attractive to potential investors. I’ll take the AAA rating, thank you. Conflict of all conflicts!
Granted, for large borrowers like the US government, all the rating agencies provide their opinion, so my "Justin’s Bond" example doesn’t necessarily apply to that exact situation. However, if you dig into the whole rating agency situation a bit more you’ll find a number of other issues as well.
So, who knows, maybe we did deserve to be downgraded, but I think investors also deserve less conflicts of interest and more transparency from the rating agencies.